BNY Mellon

Is Anybody Paying Attention?

With markets' attention focused on events in the UK, we wonder if global central banks' fight against inflation is being overlooked. Friday’s release of the US Personal Consumption Expenditure deflator for August showed that core inflation – recall that PCE inflation at 2% is the Federal Reserve's formal target – accelerated yet again, to 0.6% m/m and 4.9% y/y, both well above expectations. A day earlier, Germany's preliminary estimate for inflation (using the EU’s harmonized CPI) approached 11% in the 12 months through September. Despite some signs that supply chains are improving, we have not seen this translating into “convincing evidence” (the Fed’s current standard) that inflation is falling.

Market volatility and the potential for financial disruption and contagion to spread have in turn led market pricing for terminal rates in the US (and elsewhere) to soften. In the US, for example, since the FOMC on Sept. 20-21, 6m and 9m OIS futures have given back around 25bp on terminal-rate expectations, with rate cuts starting soon thereafter. As a reminder, we have always quibbled with this sort of pricing.

Last Thursday and Friday, Cleveland Fed President Mester and Fed Vice Chair Brainard respectively asserted that once rates get to their eventual destination, they will stay there “for a some time”; and that the Fed is “committed to avoiding pulling back prematurely”. As we wrote some time ago, the lessons learned from the early 1970s episode of high inflation suggest not only that rates need to reach positive levels in real (inflation-adjusted) terms, but also that reducing them too quickly risks a reprisal of inflationary pressures.

Yet, we wonder if investors are listening to this messaging; if they are, it would seem they are not taking these statements of intent seriously. In the chart below, we use the ECFC function in Bloomberg to obtain consensus forecasts for both G10 policy rates and inflation for 2022 and 2023; this gives us an idea of what is expected for real rates. Clearly, with inflation so high currently and rates generally still likely having a way to rise, it’s not a surprise to see such deeply negative real rates forecasts through the remainder of this year.

But for next year, we are uneasy with the consensus. We see that positive real policy rates are expected only in the US and New Zealand. Even for these two markets, the expected real rate inferred from our exercise are quite low, at just 0.2% in the US and 0.3% in New Zealand. This is far too low, in our eyes. And note: these estimated real rates are using inflation rates that are, on average across the 10 countries we examine, almost 2% lower in 2023 than they are forecast to be for this year.